Coming on 10 years of debate and development, in late 2022, the AICPA issued a working draft of its Accounting and Valuation Guide, Business Combinations (“the Guide”).1 The Guide addresses many accounting and valuation issues that have emerged over time and will help preparers, auditors, valuation specialists and other interested parties understand and comply with the requirements of FASB ASC 805, Business Combinations. While the Guide is based on U.S. GAAP, the valuation issues addressed are also generally applicable to IFRS 3 Business Combinations. With the comment period recently closed, the AICPA will be working towards finalizing this seminal work.
The development of the Guide has involved the multi-year efforts of several professional service firms, including the Big Four and valuation firms, with preparers and specialists on both the accounting and valuation subgroups. Kroll participated on the valuation subgroup.
A cornerstone of the valuation section of the Guide is a new framework to analyze the nature of intangible assets and aid in the selection of valuation methods and inputs. This framework examines intangible assets along three dimensions:
- Intangibles are first classified into IP-based assets (e.g., technology, trademarks, operating rights) and relationship-based assets (e.g., backlog, customer contracts and relationships).
- Both IP- and relationship-based assets can be further categorized into pivotal (enabling assets that are significant business value drivers, often unique and scarce—think iconic brand name), and routine (assets which provide functionality that can be accessed through a third-party in an arms’-length transaction—think internally used software).
The Guide posits that pivotal IP intangibles have two elements of value: 1) the underlying IP, and 2) the commercial value or excess profits that can be created by exploiting and commercializing the underlying IP. For example, consider a license to use a trade name currently marketed by the licensor in the U.S. whereby the licensee is going to bring it to market in Brazil by making further investments. In this example, the licensee would have to earn a sufficient return (excess profit) for commercializing the trade name after paying for the license of the underlying IP.
- The third dimension of the framework addresses how IP is accessed: it can be owned, licensed or reacquired (a situation in which previously out-licensed IP is reacquired by the licensor).
The second and third aspects of the above framework help approach the valuation of IP assets consistently, regardless of how the assets are accessed. More broadly, the foregoing framework facilitates the selection of valuation methods and inputs consistent with the pivotal or routine nature of any intangible asset.
In a classic substance-over-form exposition, the Guide dispels the myth that specific valuation methods (such as the multi-period excess earnings method [MPEEM]) must be employed to measure the value of pivotal IP assets. Contrary to a widely held perception, it is not the valuation method itself, but rather the inputs used that convey the substance of the intangible and drive the fair value conclusion. For example, a pivotal intangible asset typically valued by an MPEEM (such as a key technology that is a business driver), can also by valued by a relief from royalty method by selecting an appropriate royalty rate that captures the excess returns commanded by this asset. Royalty rates can be simulated to that effect, and the Guide discusses several ways to accomplish this. An additional benefit of this approach is that in situations in which two assets share the same income stream and are both pivotal in nature (think, a business distinguished by an iconic brand name and long-standing customer relationships), the use of multiple MPEEMs and circular cross-charges between the assets can be avoided.
The Guide also advances practice with its in-depth discussion of internal rate of return (IRR) analysis—a diagnostic tool used for assessing the prospective financial information (PFI) and discount rates used in the purchase price allocation. Special attention is given to including all elements of the capital structure in building up to the transaction business enterprise value (which reflects the price paid) and then bridging over to the transaction operating value, which is the market participant valuation of the operating business (exclusive of entity-specific synergies and non-operating assets). This provides for a more structured and rigorous analysis of purchase price, enterprise value and PFI.
Another section of the guide addresses the full spectrum of valuation approaches and techniques; circumstances in which each is appropriate; and application issues. Also discussed is the fair value measurement of various assets, including a deep dive into inventory, a detailed discussion of a wide array of intangible assets, followed by the valuation of certain liabilities.
A significant number of exhibits and Q&A illustrating concepts and calculations round off this comprehensive guide in the making.
A final version of the guide is expected to be issued later in 2023.
1.The working draft of the guide can be accessed here: https://www.aicpa.org/resources/download/working-draft-of-business-combinations-accounting-and-valuation-guide